When Interest Rates Rise, What Happens to Bonds?

Investors in longer-term Treasuries could really be punished; just as bond prices go up when yields go down, the prices of bonds will generally drop as yields (interest rates) go up.1

Quality bonds have a place in a portfolio, but many investors direct their money elsewhere as interest rates increase. Consequently, when the Federal Reserve raises interest rates, bonds tend to lose market value. So, assuming the economy stays healthy and appetite for risk stays strong, what happens to bonds and bond funds when rates begin to climb?

The impact of rising rates can vary.

Bonds and bond funds are different animals; some might even call them different asset classes.

In a rising interest rate environment, bond fund investors see principal values decline until rates level off or dip again. A diversified bond fund will reinvest interest payments into new bonds with higher coupons, however – meaning investors will see larger returns with time. 3,4

Long-term bonds tend to be hit harder by higher rates. They may lose market value, but eventually the higher rates will result in extra income for the patient investor.

How about short-term and intermediate-term bonds? Some analysts warn against purchasing short-duration Treasuries and municipal and corporate bonds, contending that these debt securities might be hurt the most should the pace of rate hikes quicken. Others disagree.

Higher rates have not always imperiled the bond market. Since 1975, our economy has witnessed six rising interest rate environments. They lasted from two to five years with T-bill rates increasing between 2.3-11.9%. In those six instances, the total annual return for Barclays U.S. Aggregate Bond Index (the S&P 500 of the bond market) ranged from 2.6-11.9%, with most of the total annual returns at between 4-6%. In short, no disaster for a bond investor. (In 2014, the total return for the index was 5.97%.)2

If the federal funds rate rises 3% over a period of a few years, a longer-term Treasury might lose as much as a third of its market value as a consequence.

Committed bond investors may exploit short-term bonds with laddered maturity dates, accepting lower interest rates in exchange for a potentially smaller drop in the market value of these securities if rates rise. Investors after higher rates of return from short-duration bonds may have to look to investment-grade bonds, but without AAA or AA ratings.

If interest rates rise sooner rather than later, exploiting short maturities could return principal back in the short term. That could provide cash which can be reinvested as interest rates go up. If bond owners expect pain in the coming years, they can limit themselves to small positions in government bonds, investment-grade corporate bonds and bond funds with durations of 10 years or less.

Bonds still belong in the big picture.
In bull markets, putting money into an investment returning 1.5% for 10 years may seem nonsensical. It may make more sense in light of the goal of portfolio diversification and the need for consistent returns. If interest rates rise significantly over the course of several consecutive years, owners of long-term bonds might find themselves losing out in terms of their portfolio’s potential. On the other hand, bonds have never lost half their value; stocks have.

Where are bonds heading? Alan Greenspan has been sounding the alarm since July of 2017 about bonds being in a bubble. In an interview with Bloomberg TV on January 31, 2018, Greenspan added a stock market bubble to his concerns, but still believes the current bond bubble to be of greater consequence. Many Americans recall that Greenspan, known as the Maestro when he led the Fed, described the dotcom mania of the 1990s as “irrational exuberance.” That memorable phrase, from late 1996, ended up being right — albeit several years early. The Nasdaq didn’t peak until March 2000.5

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